Thunderclap over Blue Sky disclosure frightens the horses

The criticism levelled at troubled Blue Sky Alternative Investments has centred on the overvaluation of its assets and excessive management fees, but it was a profit downgrade on Monday that really frightened the horses.

For Blue Sky's detractractors - and there are plenty of them - the admission from the company that profit for this year will come in as much as 44 per cent below previous expectations and that funds under management may not grow at all for the remainder of the year will cement their opinion that this listed funds manager has fundamental problems.

The company’s admission that its disclosure and transparency have been lacking comes three weeks after a report from short-selling hedge fund Glaucus unleashed a stinging critique of the value of its assets, its performance and its fees.

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The only way to combat this kind of onslaught is by immediately releasing a barrage of information as proof the assets and fees are justified and the model is sustainable.

This didn’t happen. Instead Blue Sky took on a bunker mentality.

It spent all its firepower attacking short-sellers and their financial agenda in trashing Blue Sky’s share price.

Simply calling short-sellers ill-informed won’t cut it.

And while it did release some information on Monday the real detail was confined to investments it had already sold. It is valuations of the assets currently held that are the source of concern.

There will be an independent review of the business undertaken over the remainder of the financial year which it says will "examine Blue Sky’s risk management framework, its valuation processes, financial reporting processes and other disclosures".

But those hoping that a third party accounting firm would be conducting this review will be disappointed.

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In most cases hedge funds like Glaucus do their homework, they accurately pinpoint vulnerable targets with plenty of red flags and they don’t risk investing in short positions unless they can see value at the end of the exercise.

For the average investor in Blue Sky, the natural inclination would be to sell out unless the company can give them comfort that the Glaucus research has no basis at all.

Even if the additional disclosure that Blue Sky has promised to provide satisfies some investors, it could be a long time before the whiff of concern is gone.

Blue Sky admitted that recent negative market sentiment is likely to constrain its ability to make new investments in the short term and as a result the board expects the company’s ability to generate fees to be adversely affected for the remainder of FY18.

But who is to say that this situation won’t remain a problem for the medium term and continue to constrain profits.

Chad Slater from Morphic Asset Management had some interesting points to make on Blue Sky’s dilemma both from the perspective of a fund manager that engages in short-selling and from having held a stock which was attacked by short-sellers. His fund holds no Blue Sky but he maintains that the company had some red flags.

"It doesn’t actually come as surprise to me that Blue Sky (BLA) has been singled out as a short. I have been contacted on a number of occasions over the last two years as to my thoughts on BLA’s business model from a short-sellers' perspective. Many of the issues raised by Glaucus were raised in those phone calls as a concern previously."

These include, firstly, "a business with internally valued assets".

"Businesses with assets that are 'marked to market' by company paid affiliates (auditors etc) are vulnerable to manipulation as the incentives are there for management in bonus payments, to hire someone to tell them what they want to hear. Now clearly not all companies will do this, but it is a murky area. Definitely a flag."

Flag number two, he says, is when the CEO and founder suddenly leaves and cashes out a large portion of his wealth.

Another thing Slater says to watch for is "a very young senior team that has a background in management consulting rather than industry".

Lastly a company that has grown very rapidly from a small base is another flag, he says.